Making collateral warranties interesting: the Office Depot case

The trouble with collateral warranties (CWs) is that they aren’t very interesting. Construction lawyers typically overdose on them as trainees and have had enough of them by the time they qualify. A brief foray into the world of third party rights and they are ready to move on to higher things, leaving the following cohort of trainees to pick up the next wave of CWs.

Some sections of the industry tend to pooh-pooh them as well. A vocal corner of the insurance world, with no vested interest to declare (other than a desire to sell latent defects insurance), persists in declaring that CWs “aren’t worth the paper they are written on”. (Like oral agreements, as some wag once said.) Decisions such as Parkwood, which I have previously blogged about, don’t exactly help to enhance their reputation. And the ritual pinhead dancing around net contribution and “no greater liability” clauses only reinforces the notion that CWs are little more than exercises in futility, designed to occupy the time of junior construction lawyers while their more glamorous corporate and finance colleagues get on with “real” work.

But CWs do matter!

The snag is, well, that CWs actually do matter. Just ask AMEC Foster Wheeler and FK Facades, who were – and may still be – at the sharp end of the recent Office Depot case.

This was a perfectly typical development situation. In simple terms, AMEC was the main contractor and FK the roofing sub-contractor for a warehouse building in Manchester. Each gave CWs to the landlord (UBS) and the tenant (Office Depot) in respect of their work. The roof had leaked from the start, and by 2011 UBS had lost patience and brought a claim against AMEC under its warranty. The claim was duly settled, with AMEC and FK agreeing to pay damages. They took the precaution of securing an indemnity from UBS in the settlement agreement, in case UBS should in future invoke the repairing covenant in Office Depot’s full repairing and insuring (FRI) lease and trigger a claim by Office Depot under its warranties.

So far, so good. But there was another problem. UBS decided that it didn’t want to repair the roof and would rather keep the settlement monies. This was after all 2011, and the global financial crisis was still a recent and vivid nightmare. It knew that the leaking roof was Someone Else’s Problem, both operationally and because of the FRI lease terms. So it sat back and waited to see what Office Depot would do.

A tactical blunder

It is well known that CWs have a limited life, typically 12 years from practical completion. Office Depot was aware of this and decided to do something about it before the limitation period expired. However, instead of bringing a claim under the CWs for the cost of repairing the defects, it chose to ask the TCC for a declaration as to what works were needed under the repairing covenant, and that any such works should be the responsibility of AMEC and FK.

Unsurprisingly, O’Farrell J refused to grant this declaration. I don’t intend to go into her detailed reasoning, but (spoiler alert) she noted that to do so would effectively relieve Office Depot of the risk that the chosen remedial solution might not satisfy its repairing obligation. As she pointed out, this is a risk inherent in the FRI leasing model.

So what should Office Depot have done?

Suppose that Office Depot had instead arranged to repair the defects and pursue a claim under the warranties. It had had plenty of time (at least 5 years) to investigate the cause of the leak and form its own view as to the best remedial solution. If necessary, it could also have enlisted FK (the original installer) to help with this exercise.

Of course, the repair may have proved ineffective. But – having already decided to pocket the proceeds of its earlier claim – I’d suggest that, at that point, UBS would struggle to persuade a court to enforce Office Depot’s repairing covenant. Why should UBS have its cake and eat it? At the very least, it would surely be required to apply its damages towards the cost of repair, under the principle of unjust enrichment.

Indeed, it is difficult to have much sympathy with UBS at all. You can hardly describe its behaviour as that of a “good landlord”. It clearly recognised that it was in its interests to delay pursuing a claim against Office Depot until the limitation period under the CWs had expired, so as to avoid triggering the indemnity in the settlement agreement. Leaving aside topical debates about good faith and relational contracts (and a long term lease is surely a “relational contract”), I suspect that a tribunal would strive to ensure that UBS did not gain the double benefit of a non-defective building and a damages claim.

What about the CWs?

In turn, faced with a claim by Office Depot under the CWs, what should AMEC and FK do? On the face of it, assuming Office Depot is able to prove a breach and that the repairs fall within the scope of its repairing covenant, it isn’t obvious how they might avoid liability.

Their breach has caused loss to Office Depot, for which it is liable under its lease – whether or not UBS chooses to enforce the repairing covenant. Nor is it clear how the supposed rule against “double jeopardy” might help them, in a scenario where there is a real and obvious possibility of claims under both CWs at the same time.

Will the usual “same defences” clause help them? According to the judgment, this clause appeared in AMEC’s CWs, but not FK’s. Superficially it seems as though it ought to, but (as typically worded) it will only allow the warranting party to raise defences that would have been available to it under the primary contract, had the beneficiary been named as a joint employer. So it doesn’t deal with the situation of simultaneous claims under two CWs.

We sometimes see requests to include a clause in CWs stating that the warranting party will not be liable to more than one party for the same loss. We typically resist such clauses, on the basis that beneficiaries may suffer different types of loss and shouldn’t be prevented from each recovering their own loss. However, that argument is difficult to sustain where (as here) the amounts claimed by both parties comprise the cost of repairs only.

How to resolve the dilemma?

So how is this dilemma to be resolved? Clearly it doesn’t feel right that AMEC and FK should have to pay twice to repair the same defect. Equally, it isn’t immediately obvious how to unravel the double liability problem.

I’d venture to suggest that the answer lies again in the unjust enrichment point. I have already indicated where my sympathies lie, and it must surely be right that UBS should have to account for the cost of repairs when they are actually carried out, giving credit only for the (probably minimal) loss of investment value once the leaking roof has been rectified.

I do hope I’m right, and maybe we will get to find out. The upshot of the hearing was that O’Farrell J reluctantly allowed Office Depot to amend its pleadings to formulate them as an “ordinary” defects claim against AMEC and FK. If the case is pursued, it will be fascinating to see how the court grapples with the issue. In short, maybe CWs are interesting after all.